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Full text of "Economic analysis of H.R. 5289, Natural gas policy act of 1978"

i'^Jn 9/A-ts:: IIP- 



l/ 



95th Congress 
2d Session 



COlVrMITTEE PRINT 



COMMITTKK 

Pkint i>r)-(;2 



ECONOMIC ANALYSIS 

OP 

H.R. 5289 
NATURAL GAS POLICY ACT OF 1978 



Prepared by the Staff 

OF THE 

SUBCOMMITTEE ON ENERGY AND POWEE 

COMMITTEE ON 

INTERSTATE AND FOREIGN COMMERCE 

U.S. HOUSE OF REPRESENTATIVES 



34-560 




OCTOBER 13, 1978 



U.S. GOVERNMENT PRINTING OFFICE 
WASHINGTON : 1978 



COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE 



HARLEY O. STAGGE 
JOHN E. MOSS, California 
JOHN D. DINGELL, Michigan 
PAUL G. ROGERS, Florida 
LIONEL VAN DEERLIN, California 
FRED B. ROONEY, Pennsylvania 
JOHN M. MURPHY, New York 
DAVID E. SATTERFIELD III, Virginia 
BOB ECKHARDT, Texas 
RICHARDSON PRE YE R, North CaroUna 
CHARLES J. CARNEY, Ohio 
JAMES H. SCHEUER, New York 
RICHARD L. OTTINGER, New York 
HENRY A. WAXMAN, California 
ROBERT (BOB) KRUEGER, Texas 
TIMOTHY E. WTRTH, Colorado 
PHILIP R. SHARP, Indiana 
JAMES J. FLORIO, New Jersey 
ANTHONY TOBY MOFFETT, Connecticut 
JIM SANTINI, Nevada 
ANDREW MA GUI RE, New Jersey 
MARTY RUSSO, lUinois 
EDWARD J. MARKEY, Massachusetts 
THOMAS A. LUKEN, Ohio 
DOUG WALGREN, Pennsylvania 
BOB GAMMAGE, Texas 
ALBERT GORE, Jr., Tennessee 
BARBARA A. MIKULSKI, Maryland 



RS, West Virginia, Chairman 
SAMUEL L. DEVINE, Ohio 
JAMES T. BROYHILL, North Carolina 
TIM LEE CARTER, Kentucky 
CLARExNCE J. BROWN, Ohio 
JOE SKUBITZ, Kansas 
JAMES M. COLLINS, Texas 
LOUIS FREY, Jr., Florida 
NORMAN F. LENT, New York 
EDWARD R. MADIGAN, Illinois 
CARLOS J. MOORHEAD, Cahfornia 
MATTHEW J. RINALDO. New Jersey 
W. HENSON MOORE, Louisiana 
DAVE STOCKMAN, Michigan 
MARC L. MARKS, Pennsylvania 



W. E. WiLUAMSOK, Chief Cltrk and Staff Director 
Kenneth J, Painter, First Assintant Clerk 
ELEANOii A. DiNKiNS, Assistant Clerk 



Professional Staff 



Elizabeth Harrison 
Jeffrey H. Schwartz 
Brian R. Moir 
Karen F. Nelson 
RubS David Ain 



Christopher E. Duxxe 
Wiluam M. Kitzmiller 
Mark J. Raaije 
Thomas M. Ryan 
Richard D. Lindsay, M.D. 
Lewis E. Berry, Minority Counsel 



CLARENCE J. BROWN, Ohio 
CARLOS J. MOORHEAD, California 
JAMES M. COLLINS, Texivs 
W. HENSON MOORE, Louisiana 
DAVE STOCKMAN. Michigan 
SAMUEL L. DEVINE, Ohio (ox oflicio) 



/ ■:•■ SUBCOMIVIITTEE ON ENERGY AND PoWER 

r^ I • '"' JOIIN^D. DINGELL, Michigan, Cliairman 

;KTC?rARD L. OTTINGER, N^w Yfflk 
.It<iJil«:RT (BOii) KRUEGER,,TeXcis 
'rniLIPll. SHARIMndiana / 

iNfTTlONY TOBY MOFFETT, Connecticut 

Ifk/i'il (J:\.MMA(JE.Tcx:is 

JOfl.N' M. MUKI'HY, Now York 

DA\^1^ k. SATTKKFIELD 111, Virginia 

TI.MOT^VE. WHITH. Coloriido 

A.N'DRKW ArAGUiaE, Now Jersey 

MARTY RUSSO. Illinois 

EDWARD J. MARKK Y, Mussachusotls 

IIARLEY (). STAGGERS, West Vir^-lnla 
(ex officio) 

Frank M. Porter, Jr., Staff Dirtctm and Counsel 
William D. Brain 

WiLLIA.M F. DkmaREST 

David R. SdiooLKii 

Walter W. Sciikoeder 

Kathleen Seoehson 



(FI) 



ECONOMIC ANALYSIS OF II.R. 5289, NATURAL GAS 
POLICY ACT OF 1978 



Summary 



The Natural Gas Policy Act of 1978 alters the present system of 
cost-based controls on the weilb.ead price of natural gas solci in inter- 
state commerce to a statutory price control formula applicable to 
both interstate and intrastate sales. Under the statutory formula, 
the price of new natural gas will rise from $2.06 per million Btu's today 
to about $3.70 per million Btu's at year-end 1984. On January 1, 1985, 
this gas would no longer be subject to price controls, although provi- 
sion is made for expedited review and reimposition of controls by the 
Congress if decontrolled prices rise unacceptably. The price of pres- 
ently-regulated flowing gas would remain regulated indefinitely. 

Because of the strong interest of both the Congress and the public 
in comparing the effects of the Natural Gas Polic}^ Act with the 
effects of continuing the present system of wellhead price controls, the 
staff of the wSubcommittee on Energy and Power has developed the 
following analysis. Specifically addressed are the impacts of the 
Natural Gas Policy Act versus the status quo upon major areas of 
interest, including: 

1. New Natural Gas Prices, 

2. Producer Revenues, 

3. Natural Gas Supplies, 

4. Residential Prices, 

5. Industrial Prices, and 

6. Aggregate Economic Costs and Benefits. 

The basic conclusion of this analysis is that while natural gas 
prices may be higher under this legislation than under continuation of 
the status quo, natural gas supplies will also be greater. Increased 
supplies are attributable both to the enhanced price certainty afforded 
producers and to the focusing of higher prices onto those categories of 
gas that have the greatest prospect of supply response. Based on the 
very conservative assumption that, under the status quo, the Federal 
Energy Regulatory Commission would not raise gas prices above the 
current price of $1.50 per million Btu's in real terms, domestic pro- 
ducer revenues w411 be cumulatively $23 billion greater than under the 
status quo by 1985. However, $14 billion of this $23 billion are at- 
tributable to additional production that would not be forthcoming 
under the status quo. The estimated 6 trillion cubic feet of cumulative 
additional production through 1985 will reduce imported oil require- 
ments and will reduce the balance of pa^Tnents deficit by a cumulative 
$22 bilhon. 

These findings lead to the overall conclusion that the net effect of 
the Natural Gas Policy Act will be to reduce the transfer of income 
from U.S. consumers to foreign energy producers by an amount pro- 
CD 



jected to be virtually equal to the increased income transfer from 
consumers to domestic producers. Considerable domestic economic 
and emplo}Tnent stimulus would result from the increased flow of 
dollars within the U.S. economic system. A net income transfer to 
domestic producers may also serve to increase overall Treasury 
receipts, thereby producing a positive budgetary impact. This balance 
of payments improvement would, presumably, also contribute mean- 
ingfully to a strengthening of the U.S. dollar on international money 
markets. 

Economic Analysis 

The conference agreement on natural gas pricing ^ reflects the view 
that energy pricing policy must be established in the context of 
established national economic objectives. It is recognized that a 
primary responsibility of Government is to assure that economic 
health is maintained and improved, that unemployment rates are 
reduced, and that inflationary pressures are minimized. Energy 
policy as well as other governmental programs must be pursued in a 
manner consistent with the goal of economic stabilization. 

While recognizing the need to avoid disruptive changes in energy 
prices, including the price of natural gas, it is apparent that the 
present dual market system of natural gas pricing, including cost- 
based regulation of the interstate market, is no longer tenable. The 
artificial distinction which presently exists between the interstate and 
intrastate markets must be eliminated. Therefore, the central issue 
before the conferees during consideration of this natural gas pricing 
policy was the quesion of whether market equalization should occur 
through deregulation of the interstate market, as in the Senate bill, 
or through regulation of the intrastate market as in the House bill. 

The conference agreement combines both approaches. Wellhead 
price regulation is extended to intrastate markets for the next seven 
years in order to permit an orderly transition of both interstate and 
intrastate markets to deregulation in 1985. The price of new 
natural gas from ca})ital-intensive high-cost wells is regulated for 1 
year only, while most previously discovered gas, for which little 
additional economic incentive is required to encourage continued 
production, remains regulated indefinitely. 

Because of the strong interest of both the Congress and the public 
in comparing the effects of the conference agreement with the eflects 
of continuing the ])resent system of natural gas pricing, the stalV of the 
Subcommittee on Energy and Power has developed a computer model 
to help ])rovide such a comi)arative anal^^sis. 

In a previous analysis, ^ the model was also used to compare the 
efi'ects of the Senate-passed deregulation bill ^ with the elVects of the 
natural gas jmcing ])()licy a(lo])te(l by the Ilouse.^ Several findings ot 
that previous analysis are rei)ro(hice(l in the following analysis so 
that the full array of legislative oi)tions, including no new legislation, 
may be examined. 



« The Natural Oas Poliry Act of 1078. S. Ropt OS n?n. 1078^ ,, . » o . •.♦ v .„« 

» Economic Analysis of Natiiral Has Policy Alternatlvps, CommiUoo Vrmt. PnbcoTiiiiiittno on KiicfKy 
and rowor, Conunitteo on Interstate and Foreign Commcrco, U.S. House of Koj)resentatives, December, 
1977 

» The Natural (las Act Amendments of 1077, H.R. .')289, as approved by the Senate on Oct.. 1, 1<I77. 

« I'art 4 of H. K. 8M4, the National Energy Act, as approved by the House of Representatives, Aug. 5, 1977. 



The following analysis of natural gas policy altornatives is divided 
into six sections corresponding to major areas of impact. The first 
section calculates maximum lawful new gas prices under the conference 
agreement and the House bill, and also contains estimates of new gas 
prices under the status quo and the Senate deregulation bill. Prices 
under each policy are translated into relative producer revenue 
impacts in the second section. A third section reviews potential 
natural gas supply and distribution impacts. These first three sections 
are the basis for model calculations of average residential and indus- 
trial prices in sections four and five. Aggregate economic impacts, 
including balance of pa}Tnents and inflationaiy impacts, are addressed 
in section six. Finall}', an explanation of the computer model used in 
this analysis appears as a technical appendix. 

1 . New natural gas prices 

The model specifies different prices for new natural gas, based 
upon difl'erences in the conference agreement, the status quo, the 
Senate-approved bill, and the House-approved bill. Nominal (inflated) 
new gas prices for each alternative are given in table 1 below. 

TABLE 1.— NEW GAS CEILING PRICES » 



1978 

1979 

1980 

1981 

1982 

1983 

1984 

1985 

f 1 Price per million Btu's in nominal dollars as of midyear for each year. Assumes 6 percent per year inflation. Prices are 
exclusive of gathering or processing adjustments and severance taxes or other fees. 

CONFERENCE AGREEMENT 

Under the conference agreement, the new gas price ^ is established 
at $1.75 per million Btu's beginning on April 20, 1977. This price 
increases with (1) the GXP deflator, plus (2) .2 percentage points, 
plus (3) 3.5 percentage points through April 20, 1981, or 4 percentage 
points from April 21, 1981 through December 31, 1984. Assuming 
that new gas prices after decontrol on January 1, 1985, remain on 
the trend line established prior to decontrol, the price in mid-1985 
would be $3.86 per Mcf. 

STATUS QUO 

Under a continuation of the status quo, this analysis assumes that 
interstate and intrastate new gas prices, which are presently $1.50 
and $1.82 per Alcf respectively, on average, will increase solely with 
inflation. This assumption is very conservative. These assumed con- 
stant real prices are viewed to be considerably lower than would 
likely occur under a continuation of current law, and were chosen 





Status quo (base case) 


House bill 




agreement 


Interstate 


Intrastate 


Senate bill 


1.99 


1.50 


1.82 


1.87 


2.84 


2.21 


1.59 


1.93 


2.04 


3.79 


2.42 


1.69 


2.04 


2.24 


4.73 


2.65 


1.79 


2.17 


2.44 


4.64 


2.91 


1.89 


2.30 


2.65 


4.58 


3.19 


2.01 


2.44 


2.87 


4.53 


3.50 


2.13 


2.58 


3.11 


4.50 


3.86 


2.26 


2.74 


3.36 


4.48 



* Wherever new gas prices und«r the conference agreement or the House bill are referred to in this analysis, 
they refer to ceiling prices. 



solely for analytical purposes. Under these conservative assumptions 
reflected in the analysis, consumer costs and producer revenue impacts 
exceed by a considerable margin the range reasonably expected to 
occur. 

Rather than increasing solely with inflation, the price of unregulated 
intrastate natural gas is likely to increase at a rate considerably 
gi'eater than inflation under the status quo. The near-term substitute 
for natural gas in the intrastate market is either distillate oil (No. 2 
fuel oil) or residual oil (No. 6 fuel oil). Over time, new or expanding 
users in the intrastate market are likely to bid up the price of uncom- 
mitted and new natural gas to a level equal to — if not greater than — 
the price of these substitute fuels. 

The Department of Energy projections for the industrial price of 
No. 2 fuel oil show the price increasing from about $2.85 per million 
Btu's in 1975 to $5.50 in 1985. For residual fuel oil, DOE projects 
price will increase from $2.26 to $4.50. Based upon these figures, and 
recognizing that intrastate natural gas transportation costs to indus- 
trial users average well under 50 cents per Mcf, it is not unreasonable 
to anticipate that the wellhead price in 1985 for new and renegotiated 
intrastate contracts would be in the $4 to $5 range under current law, 
far greater than the $2.74 assumption used in this analysis. 

It is also likely that the price of regulated interstate natural gas 
will increase faster than the general rate of inflation. In an effort to 
anah^ze the impact of these interstate and intrastate prices rising in 
real terms under the status quo, a ''higher price base case" has been 
estimated and referenced at several points throughout the analysis. 

HOUSE BILL 

New natural gas prices under the House-passed bill were established 
at Btu equivalence with the refiner acquisition cost of domestically 
produced crude oil. For purposes of this analysis, the present crude 
oil pricing policy is projected to continue through 1985 imder the 
assumption that statutory price control authority estabhshed by the 
Emergency Petroleum Allocation Act (as amended) will be extended. 
Under the House-approved bill, the price of new gas in mid-1985 
would reach approximately $3.36 per Mcf. 

[senate bill 

New natural gas prices under the Senate deregulation bill are com- 
puted in the staff's model according to a formula that calculates the 
price that pipelines will be willing to pay for vohimes of unregulated 
gas such that the average i)rice of natural gas delivered to low j)riority 
customers seeks to achieve Btu equivalence with No. 2 fuel oil shortly 
after 1985. This formulation results in new gas jmces rising very 
quickly, to $4.73 per Mcf in 1980 and then dro])})ing slowly during the 
next several years to a price of $4.48 ])er Mcf in 1985, after which 
prices would escalate witli the general inflation rate. Prices are highest 
when unregulated gas re])resents only a small fraction of i)ipeline 
supplies. They drop to equivalence with substitute fuels as the per- 
centage of unregulated pi|)eline sui)i)ly increases. This projected 
disorderly price i)ath under sudden deregulation is the main reason 



why the conference committee ultimately adopted a mechanism 
consisting of intrastate controls and moderate i)rice escalation to 
prepare the natural gas system for eventual decontrol. 

Many economists not familiar with the details of the United States 
natural gas system have advocated sudden decontrol as a solution 
to the problems of inadequate overall supply and inequitable dis- 
tribution. They argue that deregulated natural gas prices, like the 
price of any commodity in short supply, will rise along an orderly 
path until supply/demand equilibrium is established. However, these 
classical economic analyses should be discounted as they rely upon 
assumptions that are not applicable to the United States natural 
gas system. 

In a normal commodity market, the purchaser has a capability 
and an incentive to shop for the lowest price available among com- 
peting suppliers. However, in the nxtural gas industry the interests 
of a pipeline are by no means the same as the interests of its final 
customers. If a pipeline's rates (the price per Mcf it is permitted to 
charge) are established by its regulatory commission, the pipeline 
maximizes its revenues by maximizing throughout. The more gas 
delivered to its customers, the greater the pipeline's return. Thus, the 
immediate objective of pipeline management is to maximize deliveries. 
A pipeline short of gas suffers both lost revenues and the prospective 
loss of future industrial customers who choose not to run the economic 
risks of curtailment. The countervailing risk of paying too high a 
price for additional gas supplies is less immediate, because it will be 
many years before newly purchased natural gas will comprise a 
significant portion of the pipeline's overall gas supplies. Often, the 
risk of paying too high a price for today's supply additions is presumed 
to be deferred safely to future management. 

It appears clear, therefore, that pipeline regulation creates the 
incentive for pipelines to bid as high a price as is necessary in the short 
run to gain the desired share of additional gas volumes. These are not 
the kind of incentives that one would expect to find in a perfectly 
competitive market, and for this reason they are ignored by most 
economists. Unfortunately, these very real incentives frame much of 
the debate over the pending natural gas legislation and are central 
considerations for any relevant analysis of natural gas policy. Those 
economic analyses that have assumed perfect competition also assumed 
away the very problems that are central to a viable natural gas 
pricing policy. 

2. Producer revenues 

Projected impacts on producer revenues are an important factor in 
assessing the relative costs of alternative compromise approaches 
between the House and Senate-approved bills. An economically 
sound and equitable natural gas policy must seek to minimize any 
potential net income transfer from consumer to producers resulting 
from higher natural gas prices. In attempting to focus price increases 
onto those categories of gas for which the supply response is greatest, 
the authors of the agreement seek to increase domestic natural gas 
supplies and reduce impoarte energy requirements. In this manner, 
much of the actual income transfer resulting from the proposed legis- 
lation will be from OPEC to domestic natural gas producers. 



6 

The object of the conference agreement is therefore not to minimize 
overall domestic producer revenues but rather to minimize the income 
transfer from domestic consumers while maximizing the income trans- 
fer from foreign energy producers. In order to keep this important dis- 
tinction in focus, the following estimates of aggregate producer 
revenue impacts flowing from different pricing policies have been cal- 
culated without regard to the changes in potential supplies resulting 
from those policies. Supply impacts of different policies are discussed 
in the next section, and are also fundamental to the section dealing 
with aggregate economic impacts, including balance of payments. But 
in this section, producer revenue impacts of each pricing policy are 
calculated on the basis of future production expected to occur under 
a continuation of the status quo. The following discussion therefore 
deals with the amount by which producer revenues will increase or 
decrease solely as a consequence of the price impacts of alternative 
policies. 

Conference Agreement Versus Status Quo 

Producer revenues between 1977 and 1985 under the conference 
agreement could be anywhere from $9 billion more to about $15 
billion less than under a continuation of present law.® This range is 
attributable to the lack of certainty with respect to natural gas prices 
under the status quo. If, for example, maximum prices remain at $1.50 
for interstate gas and $1.82 for intrastate gas in real terms, the con- 
ference agreement would result in higher prices, and $9 billion higher 
producer revenues, than current law. On the other hand, under the 
more reasonable assumption of rising real prices under the status quo, 
the conference agreement would not result in significantly higher 
prices and could actually operate to limit producer revenues through 
1985. For domestic producers, this $9 billion represents a 6 percent 
increase over estimated revenues of $148 billion between 1977 and 1985 
under the status quo. 

HOUSE-APPROVED BILL 

Comparative producer revenue estimates between the conference 
agreement and the status quo were derived by first comparing each of 
these two policies with the House bill. The conference agreement woukl 
result in producer revenues that are roughly $23 billion more than 
would result from the House bill through 1985. A detailed breakout of 
the producer revenue differences between the House bill and the con- 
ference agreement ai)pears in the following table. Previous calculations 
by both the staff of the Subcommittee on Energy and Power and the 
Department of Energy found that the House bill, as compared with 
the status quo, would reduce j)roducer revenues by a total of at least 
$14 billion through 1985. The reduction in producer revenues under the 
House bill is attributable j)rimarily to provisions in the bill that freeze 
the price of most existing and rollover intrastate contracts. Present 
law permits nearly all existing and rollover intrastate contracts to 
escalate to whatever i)rice the market will bear. This more restrictive 
treatment under the House bill is virtually certain to reduce intra- 
state producer revenues relative to their expectations under the status 
quo. 



« When referred to in this section, all aggregate producer revenue impacts are expressed in temis of con- 
stant 1977 dollars. 



Comparison of producer revenue impacts of the conference agreement, relative to the 
increase over House bill, 1077 

I. New and unregulated gas: Billion 

A. New gas price and escalator -f $3. 1 

B. High cost gas -f- 1. 5 

C. Stripper -f 1. 8 

D. State roj^^lty production -f. 5 

II. New gas definition: 

A. Special developmental incentive wells: 

(a) 1978-84 +1. 9 

(b) 1985 +1.6 

B. Nonproducing reservoirs onshore +. 9 

C. New reservoirs in old leases offshore +1. 5 

III. Existing intrastate contracts: 

A. Treatment of price escalators 4-4. G-8. 

B. No rollback of interim contracts —1. 3 

IV. Intrastate rollovers: A. Minimum $1 price -f2. 7 

Total 21. 4-24. 8 

:\Iidpoint 23. 

Producer revenue increase relative to current controls ^ 7. 4-10. 8 

Midpoint 9. 

1 Assuming constant real interstate and intrastate prices. Producer revenue increases would be less if 
prices rise in real terms under the status quo. 

If producer revenues are estimated to be $23 billion more under the 
conference agreement than under the House bill, and if revenues under 
the status quo are estimated to be at least $14 billion more than under 
the House bill, then the conference agreement would increase producer 
revenues over the status quo by at most $9 billion through 1985. 

SENATE-PASSED BILL 

The Senate-passed deregulation bill has been previously estimated 
by the staff of the Subcommittee on Energy and Power to increase 
producer revenues by anywhere from $60 billion to about $75 billion 
over the House bill through the period 1977-1985. The lower end of 
this range corresponds to the case in which the Senate bill's incre- 
mental pricing mechanism provides a restraining influence on the price 
that pipelines are willing to pay for unregulated natural gas. On the 
other hand, the higher end of the range corresponds to the case in 
which incremental pricing in the Senate bill is presumed to have no 
significant influence on pipeline bidding practices. For reasons dis- 
cussed more fully in the residential price section below, the latter 
case, in which the intended price restraining effect of incremental 
pricing is not achieved, appears most applicable to the Senate dereg- 
ulation bill. 

Relative to the Energy and Power staff's high range estimate ($75 
billion) of additional producer revenues under the Senate bill, the 
conference agreement represents about $52 billion less in producer 
revenues than would result from the original Senate position. 

A summary of producer revenue impacts of the House bill, the 
Senate bill, and the conference agreement, each relative to a continua- 
tion of status quo, appears in figure 1. 



CHANGES IN PRODUCER REVENUES 
(Constant $ 1977, in billions) 



55 

50 
45 
40 
35 
30 
25 
20 
15 
10 



- 5 



10 



15 



Senate-Passed 
Bill 
+52. 



Conference 
Agreement * 
+9 



I 



STATUS 
QUO 



House-Passed 
Bill 
-14 



♦Assuming constant real interstate and 
intrastate prices. The producer 
revenue difference would be smaller 
or could even be negative if prices 
rise under the status quo. 



Figure 1 
St Natural gas supplies 

Along with their desire to minimize the consumer costs of natural 
gas pricing pohcies, the conferees attempted to focus producer in- 
centives onto tliose categories of natural gas where increased discovery 
and ])roduction a])pear most feasible. 

'J'here are only two comprehensive natural gas policy alternatives 
before the (Jongrc^ss at present. One ])olicy is a continuation of ])resent 
law. 'J'he other policy is the pro])()se(l agieement. The relevant issue 
relating to natural gas supplies is therefore whether the confen^nco 
agreement will increase supplies beyond the level expected to be pro- 





duced under the status quo. This issue is the principal focus of the 
following discussion of natural gas supplies. A qualitative analysis 
of the relative supply consequences of the Senate deregulation bill and 
the House bill is also contained in this section. 

CONFERENCE AGREEMENT VERSUS STATUS QUO 

Relative to a continuation of the status quo, the conference agree- 
ment has the potential for eliciting substantial additional gas su|)plies 
over the long run. This is because the conference agreement establishes 
higher prices on most categories of gas and concentrates the great 3st 
price increases on those categories of gas where the potential for in- 
creasing supplies is the greatest. 

The present system does not contain a proper focusing of incentives. 
For example, today's pricing system provides the same incentive for 
relatively low risk and low cost developmental drilling in previously 
discovered reservoirs as is provided for high risk exploration drilling 
in new fields. In 1976, nearly half of all extension (developmental) 
drilling was successful, whereas only one-sixth of all new field wildcat 
wells were successful. Recognizing the fundamentally greater costs an 
risks of new field exploration, many producers have taken advantage 
of the incentives for old reservoir development and are depleting 
known reserves far faster than they are finding new reserves. Against 
20 Tcf of net domestic production in 1976, reserve additions were 
only 7.5 Tcf, of which two-thirds (or 5.3 Tcf) were merely extensions 
of known reservoirs. 

The conference agreement is a departure from the present system 
in that it provides, over the next ten years, a higher incentive price 
for finding and producing from newly discovered reservoirs than from 
existing reservoirs. The greater reward for new discoveries is expected 
to result in an increase in total gas supplies. 

In addition to providing price incentives on newly discovered gas, 
upon implementation of the first incremental pricing rule one year after 
date of enactment, the agreement deregulates gas produced from new 
wells from a completion location deeper than 15,000 feet. This category 
of high-cost deep natural gas has considerable potential for increasing 
domestic supplies over the next several years. In 1976, production 
from these wells was .854 Tcf, or about 5 percent of total production. 
Over the period 1973-75, nearly 9 percent of total on-shore reserve 
additions were discovered below 15,000 feet. Deep production is 
therefore already meeting a growing share of total demand. It can 
reasonably be expected that the near term deregulation of this high- 
cost gas under the agreement will yield significant additional supplies. 
Less certain but potentially large supply additions may also occur from 
other high cost categories of natural gas, such as from Devonian shale 
or geopressurized brine. These categories, along with gas from coal 
seams, are deregulated one year after date of enactment. 

A potential near-term benefit of the conference agreement is that 
it eliminates the economic incentive to withhold gas that ma}' exist 
under the present system. In recent years, producers have faced con- 
siderable uncertainty regarding the possibility of deregulation. The 
anticipation of higher prices under deregulation provides an incentive 
to a producer to withhold gas under the expectation that, if he com- 
mits his gas to contract prior to resolution of congressional debate over 



10 

deregulation, his gas would not qualify as deregulated new gas under 
any legislation that deregulates only gas which was discovered or 
committed to contract after the date of enactment. The certain and 
relativeh' stable price path established under the agreement, plus the 
lack of vintaging, removes most if not all of the present economic 
reasons for a producer to defer or withhold his gas from the 
marketplace. 

In addition to increasing supplies relative to the status quo, the 
agreement would alter the distribution of gas between the interstate 
and the intrastate market. Because the agreement removes the pres- 
ent disparity between prices in these two markets, a greater propor- 
tion of new gas will be sold in the interstate market and a lesser pro- 
portion will be sold in the intrastate market under the agreement than 
would be the case under the status quo. Estimated interstate and 
intrastate volumes are given in table 2. 

Under the status quo, the amount of gas available under long- term 
interstate contracts is projected to decline from 10.7 Tcf in 1978 to 
7.8 Tcf in 1985. The decline in production from acreage presently com- 
mitted to interstate pipelines is expected to exceed the rate of new 
jurisdictional sales so that total jurisdictional sales will decline by an 
estimated 27 percent between now and 1985 under status quo. The 
Department of Energy's Energy Information Administration pro- 
jects a slightly faster (34 percent) decline in interstate sales to 7.3 
Tcf in 1985.^ 

Interstate sales volumes in table 2 under the status quo also con- 
tains a column referreil to as ^'nonjurisdictional sales". These are 
primarily emergency 60-day pipeline purchases and direct industrial 
purchases transported but not purchased by interstate pipelines. These 
nonjurisdictional sales are generally priced at prevailing intrastate 
levels, and are not subject to just and reasonable price determinations 
under the Natural Gas Act. As the volume of jui'isdictional sales 
declines, the pressure for volumes of nonjurisdictional sales will 
almost certainly increase. Table 2 therefore contains the projection 
that the volume of gas moving in interstate commerce at unregulated 
intrastate prices will increase from 0.2 Tcf at present to 0.5 Tcf in 
1985. Many conferees regard this predictable market trend with deep 
concern, not only because it is essentially a circumvention of the 
Natural Gas Act, but also because it directly raises consumer prices. 
By providing intrastate pipelines and prochicers a means of selling 
surplus gas without becoming subject to the Natural Gas Act, the pres- 
ent intrastate surplus may move interstate, thereby ti^^htening the 
intrastate market and leading to higher unregulated prices. In this 
])articular respect, the ])resent system is viewed as the worst of all 
])ossible worlds; increasing amounts of high-priced gas are moving on 
a short-term basis to interstate consumers, thereby removing any 
pressure on i)ro(hicers to commit their surplus or new production to 
lonii-tcrm interstate contracts. 



' Energy Information Administration, Annual Report to Congress, vol. II, 1977, p. 166. 



11 





TABLE 2.-D0MESTIC MARKETED PRODUCTION 
[Trillion cubic feetl 










Interstate 




Intrastate 


Total 






Status 


quo 


Tentative 
agreement 






Jurisdictional 
sales 


Nonjurisdic- 
tional sales 


Status quo 


Tentative 
agreement 


Status quo 


Tentative 
agreement 


1978... 

1979.... 

1980 


10.7 

10.3 

9.9 


0.2 
.2 
.3 
.3 
.3 
.4 
.4 
.5 


10.9 
10.8 
10.7 
10.6 
10.5 
10.4 
10.2 
10.0 


6.8 
6.8 
6.8 
6.9 
6.9 
6.9 
7.0 
7.0 


6.6 
6.5 
6.5 
6.5 
6.5 
6.5 
6.6 
6.6 


17.5 
17.1 
16.8 
16.5 
16.1 
15.8 
15.5 
15.2 


17.5 
17.3 
17.2 


1981 

1982... 

1983 

1984 

1985 


9.5 

9.1 

8.7 

8.2 
..... 7.8 


17.1 
17.0 
16.9 
16.8 
16.6 



The figures used in table 2 reflect ''net marketed p^oduction'^ or 
the amount that the pipehnes purchase from processing plants. This 
fig-ure does not include natural gas imports or Alaskan gas, but does 
include pipeline uses and losses as well as amounts finally delivered to 
consumers. It should be noted that estimates of production revenues 
based upon net marketed production will understate the absolute 
amount of producer revenues, because the producer also receives 
payment for gas that is used in the field or is used by a processing 
plant to convert supplies to pipeline equality. Such uses are not in- 
cluded in data on the amount of gas considered as net marketed pro- 
duction. However, since only comparative revenues are vised in this 
analysis, any underestimation of absolute producer revenues should 
not affect the amount by which producer revenues under one policy 
dift'er from revenues under another policy. 

The total gas volume estimates under the agreement used in the 
above table reflect a cumulative production increase over the status 
quo of about 6 Tcf between 1978 and 1985. This production response 
results from a projected increase in reserve additions of 3 Tcf per 
year, which yields an increase in annual production that grows from 
zero in 1978 to slightly less than 10 percent of production (1.4 Tcf) by 
1985. If a more conservative supply response of 3 Tcf between 1978 
and 1985 is assumed, total domicstic production is estimated to be 
about 15.9 Tcf by 1985, an increase of 5 percent over the status quo. 

Another likely effect of the agreement would be to encourage the 
production of domestic gas supplies and discourage the use of imported 
LNG. Under the present system, because prices in the interstate 
market are kept artificially low, the high price of imported LNG can 
be averaged, or ''rolled in," with lower priced domestic supplies, while 
keeping delivered natural gas prices at or below the price of competing 
fuels. Present law thereby shields users of imported gas from its higher 
costs by having all gas consumers share that cost. 

The agreement, with its higher prices for domestic supplies and 
incremental pricing, creates a less favorable environment for pipelines 
to pursue their plans to import higher cost LNG. Thus, the agxeement 



12 

directly discourages reliance on foreign sources of natural gas, result- 
ing from the effective subsidy created by the present price control 
system. 

SENATE BILL 

Although producer revenues under the Senate-passed bill would have 
exceeded those under the agreement by $52 billion between now and 
1985, the Senate-passed bill would have resulted in only a shght in- 
crease, if any, in reserve additions and production. 

The primary reason for the lack of additional expected supplies is 
that a large part of the increased revenues under the Senate-passed 
bill would have been attributable to significant increases in unregu- 
lated prices for old intrastate gas. The Senate deregulation bill would 
have left all gas that is presently unregulated, including previously 
discovered intrastate gas, free from price controls. There is little 
expectation that any increases in production would result from higher 
prices for this category of gas. 

A second factor contributing to the view that production would 
not be considerabl}^ increased b}^ the Senate bill is that for those 
categories of gas where the potential for increased production is 
greatest, the conference agreement provides incentive prices that are 
comparable to incentive prices under the Senate-passed bill. Anah'sis 
of both bills indicates that in 1984 the new gas price under the 
Senate-passed bill would exceed that under the agreement b}' only 
about 60 cents per Mcf in constant dollars. And in 1985 new gas 
would no longer be subject to price controls under either bill. Thus, 
over the long term, the incentive price under the Senate bill is the 
same as under the agreement. Between now and 1985, an}^ suppl}'- 
response due to higher prices under the Senate bill are expected to be 
minimal. The Senate-passed bill would result in higher new gas prices 
in the short term, but, because major exi)loration and chilling invest- 
ment decisions are based on long-term rather than short-term price 
expectations, the higher short-term prices under the Senate bill are 
not expected to elicit a supply response significantly greater than 
would result from the agreement. In addition, as discussed above, 
even over the short run the agreement deregulates several categories 
of high cost gas, incluchng gas produced from new wells from a com- 
])letion location deeper than 15,000 feet. For these categories of high 
cost gas, the agreement provides price incentives that are identical to 
those of the Senate bill. 

Lasth% although the Senate bill provides higher deregulated prices 
for all new oil'shore gas sooner than mider the agreement, the con- 
ferees believe that ofi'shore j)roduction is at least as sensitive to leasing 
policy as it is to i)ricing policy. The higher i)rices allowed under the 
Senate bill for new offshore gas could not be ex])ected to elicit any 
meaniiigfid additions to total domestic natural gas sup])ly, unless new 
leases were made available more rai)idl3' than has been the past 
practice. 

HOUSE BILL 

Because of the higher ju-ices allowed under the agreement relative 
to the Il()use-])asse(l bill for those categories of gas with a ])otential 
for increasing su])i)lies, it is expected that i)roduction under the agree- 



13 

ment will be significantly higher than it would have been under the 
House bill. The conferees beHeve that production under the House 
bill would have been close to that under the status quo, even thougii 
producer revenues would be significantly lower under the House bill 
than under the status quo. This is because the House bill would have 
reduced prices on old gas, where little impact on production would 
result, but allowed new gas prices comparable to those under the 
status quo. 

.4. Besidential prices 

Conference Agreement Versus Status Quo 

Under the conference agreement, incremental pricing will retard 
the rate of increase in the average price of gas to interstate residential 
customers so that between now and 1983 the price will rise at a rate 
nearly identical to the rate of residential price increases under con- 
tinued Federal regulation of interstate sales for resale. After 1983, 
when incrementally priced industrial customers have reached the 
spillover price, residential prices will rise to levels somewhat higher 
under the conference agreement than under present law. The average 
interstate residential price under the conference agreement is expected 
to rise from today's level of about $2.50 per Mcf to about $4.80 per 
Mcf (nominal dollars) in 1985. The residential price in 1985 under 
continued regulation would rise to roughly $4.70 per Mcf under the 
low-price base case assumptions. This 10 cents per Mcf difference in 
1985 would am.ount to about $13 per year in an average interstate 
residential customer's fuel bill. 

However, this potentially higher direct cost of gas to residential 
customers must be taken in context. Increased avail abilit}'" of natural 
gas to interstate pipelines will permit an expansion of residential inter- 
state consumption. New residential customers will benefit from the 
agreement by avoiding higher cost alternative energy forms. Reduced 
use of fuel oil and electricity will result in aggregate savings to the 
interstate residential consumer sector be^^ond those reflected in the 
above direct cost comparison. Also, under the higher price base case, 
a small reduction in residential consumer costs would occur. 

In addition, residential interstate prices under the conference agree- 
ment Avould be reduced b}' 20 cents per ?\Icf in 1985 if the second 
incremental pricing rule rec[uired to be developed by the Federal 
Energy Regulatory Commission is accepted by the Congress. The 
reduction in residential fuel bills would average about $25 in 1985. The 
second rule would broaden the category of increment alty priced inter- 
state industrial users, thereby- postponing the date on which incremen- 
tally priced users reach spillover and begin to state increased costs 
with residential customers. 

The average intrastate residential price is expected to grow under 
the conference agreement from, the present average of $1.80 per Mcf 
to $3.80 in 1985. Under the status quo base case, intrastate residential 
prices in 1985 are forecast to be about $3.45 per Mcf. The added cost 
in 1985, relative to the status quo, would be about $30 per year for 
intrastate residential customers. 



14 

Under the higher price base case, intrastate residential prices in 1985 
are projected to be about $4.75 per Mcf. The reduced cost in 1985 to 
residential consumers under this case would be about $100 per year. 
Consequently, the impact of the conference agreement on intrastate 
residential consumers could be slightly negative, but the m.ore probable 
result is slightl}' lower prices than would be the case under the status 
quo. 

HOUSE BILL 

Under the House bill, average residential prices would grow approxi- 
mately at the rate of inflation through 1985, which is a slower rate of 
growth than under either the conference agreement or under a con- 
tinuation of present law. In 1985, interstate residential prices would be 
about $4 per Mcf under the House bill. Intrastate residential prices 
under the House bill would be roughly $3 per Mcf. 

Lower residential prices under the House bill are attributable to its 
incremental pricing mechanism. The House bill called for increases in 
natural gas prices to be borne initially by a broadly defined group of 
low priority users until the price of natural gas delivered to those low 
priority users reaches the price of substitute fuels (distillate, or No. 2, 
fuel oil). Through 1985, however, tlie delivered price to incrementally 
priced low priority users under the House bill is forecast to remain be- 
low the distillate equivalent price. Hence, no significant increase in the 
real price of natural gas to interstate or intrastate residential cus- 
tomers would be anticipated under the House bill until after 1985. 

Residential i)rices are higher in 1985 under the conference agree- 
ment than under the House bill not only because the conference agree- 
ment establishes higher maximum lawful prices, but also because of 
differences in the incremental pricing mechanisms contained in the 
two programs. Incremental pricing in the conference agreement apjihes 
only to interstate markets, whereas the House bill would have applied 
incremental ])ricing to intrastate markets as well. This is the major 
reason wh}^ intrastate residential customers would pa}' higher rates 
under the conference agreement ($3.80 per Mcf) than under the House 
bill ($3 per Mcf). Another significant difference is that only natural 
gas selling for more than $1.48 per million Btu's is incrementally 
priced under the conference agreement, whereas the House bill in- 
crementally priced any real increase in a j)ipeline's natural gas acquisi- 
tion costs. As a consequence, all natural gas that increases in })ri('e 
but which remains below $1.48 i)er Mcf does not get incrementally 
j)riced under the conference agreement, but would be incrementally 
priced under the House bill. This difference means that interstate 
residential customers are not as sheltered from ])rice increases under 
the conference agreement as under the House bill. 

Finally, the number of incrementally priced low priority users is 
smaller under the conference agreement. Aside from the fact that 
incremental ])ricing under the conference agreement ai)plies only to 
interstate customers, the conference agreement recpiires that only 
large industrial })oiler fuel customers be incrementally ])riced. The 
House bill, on the other hand, lecpiired virtually all low priority 



15 

customers, including electric utilities and industrial process and 
feedstock users, to bear incremental ])r"ices. The })roa(ler ])ool of users, 
incrementally i)riced under the House bill causes the spillover pric;e to 
be reached later than under the conl'erent^e agreement. The cond)i- 
nation of higher wellhead prices and a smaller j)ool of incrementally 
priced users under the conference agreement results in higher 1985 
residential prices than under the House bill. 

SENATE BILL 

The incremental pricing provision of the Senate bill is an amendment 
to the Natural Gas Act. As such, the provision is subject to the juris- 
dictional limitations of that act. Under section 1(b) of the Natural 
Gas Act, the authority of the Federal Energy Regulatory Commission 
is limited to the rates and charges of interstate pij)elines and does not 
extend to the rates of local distribution companies. It is the local 
distribution companies which actually supply residential consumers, 
as well as the majority of the industrial users of natural gas. Thus, 
although the Senate bill does require a segregation of low cost and 
high cost gas supplies at the pipeline level, the bill permits a local 
distribution company to roll the segregated prices of its gas supi)lies 
together before passing its costs on to residential and industrial 
consumers. Because the incremental pricing mechanism of the Senate 
bill applies only to interstate pipelines and not to their distribution 
companies, it is ineffective as a means of preventing wellhead price 
increases to be ''rolled in" and thereby borne by residential users. 

Given the history of regulation of local distribution companies at 
the State level and considering the economic and regional competition 
issues involved, in view of the absence of a mechanism in the Senate 
bill to prevent rolled-in pricing at the local distribution company 
level it is reasonable to assume present State regulatory practices, 
under which rolled-in pricing is the general rule, would continue 
following enactment of the Senate bill. 

Both the House bill and conference compromise are radically 
different from the Senate bill in this respect. The House bill and the 
conference compromise prescribe detailed mechanisms which apply 
the incremental pricing requirements of each to local distribution 
companies as well as to pipelines. Under each, the pass through of 
higher prices to low priority users flows through to the burner tip. 

The Senate bill would cause average pipeline acquisition costs of 
natural gas to reach approximately $4 per Mcf in 1985, more than 
$1 per Mcf higher than the average pipeline acquisition cost under the 
conference agreement. Assuming that local distribution companies 
choose to roll in rather than pass through incremental charges to low 
priority customers, the resulting price to interstate residential custom- 
ers would be in the range of $6 per Mcf in 1985. The price to intra- 
state residential customers would be somewhat lower, about $5 per 
Mcf, due to the lower transportation costs in intrastate markets. 



16 

A summary of the increased residential prices that would result 
under the agreement, the status quo, and the House and Senate bills, 
appears in figure 2. 



RESIDENTIAL PRICES IN 1985 

[PrFce Increases under higher price boae case 
Price increases through 1985 



Price in 1978 



6.00 




5.00 



agrmt. agrmt. statua house senate agrmt. status house senate 
without with quo bill bill quo bill bill 

second second 



INTERSTATE 



INTRASTATE 



This table represents direct price increases under each aKernatlvc and does noi 
reflect the savings associated with those alternotives which increase natural gas 
supplies and there by reduce overall residential expenditures for fuel oil or electricity. 



Figure 2 



5. Industrial Prices 



Conference Agreement Versus Status Quo 

Incrementally priced interstate boiler fuel customers, who represent 
ai)proximately 1.1 to 1.2 Tcf (or about 10 percent) of interstate de- 
mand, will experience rapidly escalating delivered natural gas costs 
under the conference agreement. If the second incremental pricing 
rule does not take effect, the price to such customers will increase from 
$1.40 per Mci" today to about $4.50 per Mcf in 1983, at which point 
the average interstate boiler fuel customer will reach the spillovcr- 
(alternative fuel) i)rice. Beyond 1983, the cost of gas to most incre- 
mentally priced industrial customers will rise slightly above the pro- 
jected jjrice of No. 2 fuel oil to a level of about $5.60 i)er milhon Btu's 
in 19S5. The cost of gas to an}' incrementally priced user granted a 
reduction in its alternative fuel j)rice would rise to slightly above the 
price of Xo. 6 fuel oil, projected to be $4.50 per milHon Btu's in 1985. 



17 

Under the status quo, these users would pay ai)i)roximately $2.70 
per Mcf in 1985. 

If the second incremental pricing rule is rejected by Congress, the 
price of gas to non-incrcmentally i)riced interstate industrial and 
utility customers will grow considerably less rapidly than to incre- 
mentally priced boiler fuel users. The cost to non-incrementally i)riced 
users is expected to rise from $1.40 to about $3 per Mcf. 

If the second incremental pricing rule is a(lo])ted, as much as 5 Tcf 
of interstate demand would be required to share the effects of incre- 
mental i)ricing. Such sharing would work to the benefit of large boiler 
fuel users subject to the first rule, whose ])rice in 1985 would be about 
$4 per Mcf under the second rule as compared with more than $5.50 
per Mcf if onl}' the first rule is in efiect through 1985. The price to 
non-incrementally priced customers, including residential customers, 
will be lower in 1985 if the second incremental pricing rule is adopted, 
because the spillover price is not expected to be reached under the 
second rule until after 1985. The benefi.t of the second incremental 
pricing rule to non-incrementally priced interstate users in 1985 is 
estimated to be about 20 cents per Mcf. 

Intrastate industrial prices under the conference agreement are 
forecast to grow from $1.40 to about $3.30 per Mcf in 1985; under the 
status quo, these prices would be about $2.90 b}^ 1985. Under the 
higher price base case, these prices would be about $4.25 in 1985. 

SENATE BILL 

Average interstate industrial prices under the Senate deregulation 
bill are projected to be about $4.70 per Mcf in 1985. The price to 
interstate industrial users would be considerably higher than this 
figure if incremental pricing in the Senate bill is assumed to flow 
through to the burner tip rather than being rolled in at the disttribu- 
tion company level. In the intrastate market, industrial prices would 
be slightly lower, about $4.45 per Mcf, due to lower transportation 
charges and the absence of incremental pricing. 

HOUSE BILL 

Under the House bill, which would apply incremental pricing to 
intrastate as well as interstate industrial users, the price to such users 
in 1985 would be about $5.20 per Mcf. This high price shows that in- 
dustrial customers would have borne virtuall}^ all of the increase in 
pipeline acquisition costs under the House bill. The conference agree- 
ment incremental!}^ prices only that portion of an interstate pipelme's 
acquisition cost of new, special developmental, intrastate rollover, or 
LNG gas supi)lies which exceed $1.48 per million Btu's. The size of a 
pipeline's incremental passthrough account would be smaller under 
the conference agreement than under the House bill. And if borne by 
a broad class of users under the second incremental pricing rule, in- 
crementally priced users under the conference agreem^ent would pay 
at least $1 per Mcf less than under the House bill in 1985. 



18 

A summary of increases in industrial prices resulting from the agree- 
ment, the status quo, and the House and Senate bills appears in 
figure 3. 



INDUSTRIAL PRICES IN 1985 

Price Increaaes under higher price base case 
Price increaaea through 1985 
Price in 1977 



< 
en CD 

u 




agrmt.. agrmt. 

w/o with 
second second 
rule rule 



interstate: 
ihjcrementally-priced 

USERS 



INTERSTATE 

NOT I NCREMENTALLY-PR I CED 

USERS 



INTRASTATE 
USERS 



Figure 3 



6. Aggregate economic costs and benefits 

The relative economic costs and benefits of any natural gas pricing 
policy cannot be evaluated solely on the basis of domestic producer 
revenue im])acts or increases in dehvered natural gas prices. The im- 
pact on the overall economy is a function of both j)rice and supj)ly. 
Different j)olicies, to the extent that they result in different volumes of 
domestic gas production, will also result in different requirements for 
imported enei'gy. A significant supply i-esponse for natural gas would 
permit the United States to meet its conventional energy needs with 
correspondingly diminished reliance on imported oil and natural gas. 
This analysis assumes that any adtlitional domestic natural gas pro- 
duction, relative to the status quo, resulting from the conference 
agreement would displace substitute imported fuels that would other- 
wise cost, on average, 10 ])ercent more than the price of No. 2 fuel oil. 

Pi-ojections contained in the section dejding with natural gas sup- 
j)lics indicate that the conference agreement will result in a significant 
increase in total domestic natural gas production relative to tlie status 
quo. Marketed domestic natural gas production in 1985 is projected 



19 

to be as much as 1.4 TcT creator under (he confei-enee aii^reemont than 
under the status quo. This incremental j)ro(luc(ion is e((uivalent to 
about 700,000 barrels per day of imported oil, nearly 10 j)ercent of 
our current oil import level. If the 6 Tcf of total additional j)roduction 
between now and 1985 detailed in the above sup])ly resj)onsc section 
is actually produced, a sii^nificant reduction in })ayments for imported 
energy supplies will occur. In 1985 alone, a 700,000 barrel i)er day 
reduction in imported eneruy would im|)rove the U.S. balance-of- 
paj'ments position by more than $4 billion. 

As compared to the status quo base case, domestic gas i)roducers 
are projected to receive approximately $14 billion more between now 
and 19S5 for the additional production stimulated by the conference 
agreement as well as $9 billion in additional revenues for status quo 
production. The combination of higher prices and increased supplies 
arising from the agreement are therefore estimated to raise total 
domestic producer revenues by about $23 billion over the status cjuo 
base case between now and 1985. However, the increase in domestic 
natural gas supply will displace approximately $22 billion in imported 
and other high-cost energy^ requirements that would be consumed in 
the absence of increased domestic natural gas production under the 
conference agreement. The additional revenues to producers under 
the ao^reement and the additional costs to consumers, if any, are not 
identical. The reduction in substitute fuel costs must be subtracted 
from gross domestic producer revenue gains in order to assess the net 
aggregate impact on U.S. consumers. 

Thus, during the period from now through 1985, consumers would 
pay $23 billion more to domestic gas producers under the conference 
agreement as compared to the status quo base case. How^ever, they 
would also pay nearly $22 billion less to foreign sources for heating 
oil, liquefied natural gas, and imported natural gas, so that the overall 
net cost to consumers of the tentative agreement would be only about 
$1 billion between now and 1985. If a less optimistic 3 Tcf supply 
response is assumed, the import credit would also be lower so that 
the net economic cost of the conference agreement would be closer to 
$5 billion. 

These findings lead to the overall conclusion that the net effect of 
the conference agxeement will be to reduce the transfer of income from 
United States consumers to foreign energy producers by an amount 
projected to be virtually equal to the increased income transfer from 
consumers to domestic producers. Although not explicitly factored 
into this analysis, considerable domestic economic and emplo^Tnent 
stimulus would result from the increased flow of dollars within the 
United States economic system. A net income transfer to domestic 
producers may also serve to increase overall Treasury receipts, thereby 
producing a positive budgetary impact. This balance of payments 
improvement would, presumably, also contribute meaningfully to a 
strengthening of the United States dollar on international money 
markets. 

And if, as argued at the outset of this analysis, producer revenues 
would increase by considerably less than $23 billion, the net impact 
on consumers and on inflation could w^ell prove to be positive. Under 
the higher price assumption of rising real prices under the status quo, 



20 

the net benefits to consumers between now and 1985 would be $15 
billion. 

Even the $1 billion and $5 billion cost of the conference agreement 
associated with the ''worst case" assumptions is far below the threshold 
of what is generally considered a major inflationary action. Over the 
next 7 years, the cumulative Gross National Product will exceed 
$15 trillion. A $1 billion to $5 billion inflationary measure would add 
only .007 to .035 percentag;e points to the prevailing level of inflation. 
In general, measures contributing less than one-tenth of a percentage 
point to inflation are not considered significantly inflationary. 

The costs and benefits of the conference agreement may also be 
analyzed with respect to both the interstate and intrastate markets. 
It should be emphasized that the economic impacts as projected by 
the model are highl}" aggregated. Although the model does distinguish 
between the interstate and the intrastate markets, it does not contain 
the detail necessary to break its results down into state level or regional 
level impacts, except to the extent that the intrastate market may be 
considered as broadly regional. Model results outlined below reflect 
projected impacts on the market system as a whole rather than on 
the individual states. Thus, to the extent that the characteristics of 
any particular state deviate from the norm for the market system as 
a whole due to State regulations, policies, or geographical circum- 
stances, the model results must be carefully interpreted and qualified 
to reflect the impact of the specific characteristics on any given State. 
The model also does not analyze any relationships between the con- 
ference agreement and recent court decisions interpreting the Natural 
Gas Act which may potentially aft'ect regional cost and benefit 
estimates. 

The overall costs and benefits of the proposed legislation to specific 
regions or markets will be a function of changes in either supplies or 
prices of natural gas for those markets. Interstate markets, under 
either base case assumption, will benefit from the agreement because 
of increased supplies of gas available to interstate pipelines. And even 
though prices of natural gas to interstate consumers will rise in absolute 
terms, the price will remain below the delivered cost of alternate 
fuels. In this manner, the increased availability of gas to interstate 
consumers displaces higher priced fuels and thus reduced aggregate 
interstate energy costs. A preliminary estimate of the relative economic 
costs and benefits indicates that interstate consumers, in the aggregate, 
will pay $6 billion to $10 billion less for their energy between now and 
1985 with the tentative agreement. 

With resj)ect to the intrastate market, the savings in cost of intra- 
state consumers are also estimated to be $6 billion if prices are as- 
sumed to rise in real terms imder the status quo, as re])resented by the 
higher ])rice base case. However, increased intrastate costs of $7 
billion will result from the agreement if intrastate ])rices arc assumed 
to rise no faster tlian inflation under the base case and if fuels sub- 
stituting Tor any displaced natui-al gas are higher priced. 

As has been pointed out earlier, ])j-edicting future ii\trastate prices 
under the status quo is extremely diflicult. Over the next few years, 
the current intrastate surj)lus is a|)t to jM'oducc a dej)ressing im])act on 
intrastate prices. Over the slightly longer term, however, the price of 
unregulated intrastate gas under the status quo would be expected to 



21 

rise significantly toward the equivalent price of dislillate oil or re- 
sidual oil. Therefore, the most reasonable assessment of the impact of 
the agreement on intrastate markets is between the $7 l^iUion cost to 
$6 billion benefit extreme points. 

The $7 billion ''worst case" cost estimate for the intrastate market 
also significantly exceeds the impact that can reasonably be expected to 
be attributed to the agreement for another reason. The $7 billion cost 
estimate is derived from the assumption that natural gas supplies will 
be displaced as a result of the agreement and that high-])riced petroleum 
or imported natural gas will substitute for such displaced supplies. 
However, in large part, this intrastate fuel displacement will not result 
from the agreement but rather from independent investment com- 
mitments by utilities and regulatory actions by States aimed at 
significantly reducing boiler fuel use of natural gas by 1985. Consumer 
savings will result because much of the substitution will be directed 
toward coal rather than higher priced petroleum or natural gas. 

In any case, intrastate consumers would benefit from an increase 
in State royalty and severance tax receipts and economic activity 
that would be stimulated b}^ the conference agreement. These in- 
creased receipts will permit reductions in state and local income or 
property taxes. 

Appendix 

model explanation 

To measure the various economic impacts of different pricing 
policies, the model that serves as the basis for this anal^'sis is divided 
into five sectors. The first sector consists of exogenous (externally 
specified) gas volumes and wellhead prices for each 3^ear between now 
and 1985. The other four sectors use these volumes and prices to 
calculate delivered residential prices, delivered industrial prices, 
aggregate consumer costs and producer revenues. The calculations 
used by the model can be modified to reflect the provisions of the 
policy that is to be analyzed. An explanation of the calculations used 
within the five sectors to measure the impacts of the conference 
agreement, relative to a continuation of the status quo, is given below. 

Volumes and wellhead prices 

The supply sector of the model reflects the general^ held assumption 
that higher prices under the Agreement will result in increased reserve 
additions and, over time, increased gas production. Two alternate 
supply response scenarios can be analyzed. The first scenario assumes 
that additional production will be .01 Tcf in 1978 and will increase to 
1.45 Tcf in 1985 (for a total supply response of about 6 Tcf), as in- 
creased prices spur exploration and discovery. This supply response 
reflects a long-run supply elasticity assumption of .02. The second 
scenario assumes a total supply response of 3 Tcf between now and 
1985, and reflects a supply elasticity of 0.1. This range of supply 
elasticities extends well above and below the supply elasticity value of 
0.13 computed by the Office of Technology Assessment in 1977. 

Volumes of old gas are based on historical values declining at 7 to 
8 percent per year. Volumes of gas from new wells reflect production 
of 10 percent of new reserves per year, based on the assumption that 



22 

the average life of a new reserve is about 10 \ears. Under the status 
quo, all gas from new reserves as of 1977 is considered new gas. Under 
the conference agreement, production from new reserves is divided 
into special developmental incentive gas and new gas. The proportion 
that is special developmental incentive (extension) gas declines from 
its present level of about 70 percent to 50 percent by 1985, as develop- 
ment of new reservoirs replaces development of existing reservoirs. 

Under both scenarios, old gas under existing contracts is divided 
into the following categories: interstate contracts, intrastate contracts 
that are likely to be less than $1 per Mcf at time of rollover, and intra- 
state contracts that are likel}^ to be greater than $1 per Mcf at time 
of rollover. The volume of gas in each category is initially set at its 
value as of 1977 and declines over time as production declines and 
contracts roll over to their respective categories. Interstate rollover 
rates are based on rollover profiles as contained in an appendix to 
FPC Opinion 699, and confirmed in data supplied to the Subcommittee 
on Energy and Power by the 10 largest interstate pipelines. Rollover 
rates for intrastate pipelines are assumed to be 8 percent per year for 
intrastate contracts below $1 and 10 percent per year for intrastate 
contracts above $13 reflecting the fact that more recently entered 
intrastate contracts are at higher prices, and are generally of shorter 
duration. 

Production from new reserve additions is eligible for the same 
maximum lawful price whether sold in intrastate or interstate markets. 
The model contains the assumption that this gas will tend to be allo- 
cated primarily by demand. Thus, in accordance with present demand 
patterns, it is assumed that 60 percent of future discretionary produc- 
tion volumes will be committed to the interstate market and 40 per- 
cent will remain within the intrastate market. Under a continuation 
of the status quo, the proportions are a function of the relative inter- 
state and intrastate prices, and result in a growing share of gas going 
to intrastate markets. 

In determining wellhead prices under the Agreement, the model 
assumes that the prices will rise to the statutory ceiling price as 
applicable to the following categories of gas: new gas, special develop- 
mental incentive gas, interstate rollovers, and intrastate rollovers 
both below and above $1 at time of rollover. The prices for gas under 
the three categories of existing contracts (i.e., existing interstate, 
existing intrastate below $1 and existing intrastate above $1) are 
initially set at their ])resent average values, which are 70 cents 
mmBtu, 37 cents/mmBtu and $1.74/mmBtu, respectively. Prices in 
real terms are assumed to remain constant under existing interstate 
contracts and intrastate contracts priced below $1 at time of rollover. 
The price under existing intrastate contracts priced above $1 at time 
of rollover, however, is assumed to increase to the new gas price over 
the next 4 years. Such contracts generally have indefinite ])rice esca- 
lator clauses that allow the contract price to rise to the prevailing 
market j)rice. 

As discussed in the body of this analysis, the model assumes that, 
under a continuation of the status quo, both interstate and intrastate 
new gas prices would remain at their current levels of $1.48 per 
mmBtu and $1.82 per mmBtu, respectively. 



23 

Existing? contract prices are assumed to be essentially the same 
under the status quo as under the A^ireement, allhou<ih intrastate 
contracts with indefinite price escalator clauses wouhl he ])ejniilted to 
escalate to the new gas price under the Conference Agreement, whereas 
they are assumed to rise only to $1.82/mmBtu under the status quo. 
All intrastate rollover contracts are subject to these same assumptions. 

Delivered residential prices 

To determine delivered residential prices under a continuation of 
status quo, the model simply adds a tj-ansportation and distiibution 
charge to the average wellhead price for the interstate and intrastate 
markets. The transportation and distribution charge is the sum of the 
existing average transportation and distribution charge and a variable 
component that reflects changes in overall future pipeline capacity 
utilization relative to utilization in 1977. The existing average trans- 
portation and distribution charge is assumed to be 60 cents per Mcf 
in the intrastate market and $1.60 per Mcf in the interstate market. 

The calculation of delivered intrastate residential prices under the 
Agreement is the same as that under a continuation of the status quo: 
a transportation and distribution charge is added to the average intra- 
state wellhead price. In detemiining interstate residential prices, the 
incremental pricing provisions of the Agreement have been incor- 
porated into the model. Prior to the ''spillover point" at which 
industrial users reach Btu-equivalence with substitute fuels, the base 
price that is chargied to residential customers (excluding transporta- 
tion and distribution charges) is calculated as though all gas from 
new wells had a ceiling price of $1.48/mmBtu. The amount by which 
the actual price exceeds $1.48 is put into a separate account to be 
allocated to incrementally-priced users. After the industrial users have 
reached Btu-equivalency, an additional component is added to the 
base price charged to residential customers to reflect the allocation of 
any additional price increases to all users. Both before and after the 
spillover point, a transportation and distribution charge comparable 
to that under the status quo is added to the base price to determine 
the total delivered price to interstate residential customers. 

Delivered industrial prices 

Under a continuation of the status quo for both the interstate and 
the intrastate market and under the agreement for the intrastate 
market, the calculation of delivered industrial prices is similar to that 
of residential prices under the status quo: a transportation charge is 
added to the average wellhead price. The transportation charge 
reflects the existing average transportation charge (57 cents/mmBtu in 
the interstate market and 25 cents/mmBtu in the intrastate market) 
and changes due to variations in pipeline capacity utilization relative 
to the 1977 level of utilization. 

In deteiTnining interstate industrial prices under the Agreement, the 
effects of incremental pricing are again measured. Before the point in 
time at which spillover is reached, the industrial user pays $1.48/ 
mmBtu for any incrementally-priced supplies, plus his portion of the 
incremental surcharge account reflecting amounts attributable to price 
increases above $1.48, plus a transportation charge. After the delivered 



24 

price of natural gas to incrementall}^ priced users reaches Btu-equival- 
ence with the deUvered price of substitute fuels, the industrial user 
pays that Btu-equivalent price, plus a component reflecting the alloca- 
tion of any additional price increases to all users, under the assumption 
that such increases are rolled in to all users. 

Through this formulation, the model can easily reflect the effects of 
incremental pricing on interstate industrial and residential consumers, 
and compare the resulting prices to those in the intrastate market as 
well as to prices under the status quo for each year between now and 
1985. 

Aggregate consumer costs 

To detemiine aggregate consumer costs, the model examines the 
amount of gas available, the price at which it is available, the amount 
of alternative fuel that would be needed to supplement that gas to 
meet demands, and the price of the alternative fuel. From this informa- 
tion, the model computes aggregate consumer costs for both the inter- 
state and the intrastate markets. As gas that would remain within 
the intrastate market under the status quo is sold instead into the 
interstate market under the Agreement, additional amounts of alterna- 
tive fuels must be purchased by intrastate consumers. On the other 
hand, because the Conference agreement makes additional supplies 
available to the interstate market, the higher cost of an equivalent 
amount of alternative energy supply can be backed out of the calcula- 
tion of aggregate interstate consumer costs. This substitute fuel credit 
in the interstate and the substitute fuel cost in the intrastate market 
is then combined to give a total aggregate consumer cost for the 
Nation as a whole. 

Producer revenues 

Total producer revenues are calculated simply as the product of the 
amount of gas that is sold and the average price at which it is sold. 
To compare producer revenues under the agreement with those under 
a continuation of the status quo, the model can operate under one of 
two options. Under the first option, the model calculates producer 
revenues for a fixed amount of gas. This option compares the addi- 
tional revenues that producers would receive under the Agreement for 
a given amount of gas equal to volumes projected to be produced under 
the status quo. This measure of producer revenues separates the effect 
of higher prices (and the resulting inflationary impact on consumers) 
from the effect of increased revenues arising from added production. 
The conferees were interested in minimizing the former, inflationary, 
measure of their agreement. Revenues attributable to increased 
production need to be calculated separately in order to make this 
important distinction. 

Under the second option, the model assumes a supply response and 
calculates the amount by which total producer revenues would in- 
crease as a result of higher i)rices and increased sales under the 
agreement. 

o 



UNIVERSITY OF FLORIDA 



3 1262 09119 2988